By GRAHAM FROST 12/09/2008
Last Sunday the US Treasury rescued the two largest issuers of mortgage backed paper, known as Freddie Mac and Fannie Mae. The share capital of these entities, like Northern Rock, was effectively wiped out. Rather than a nationalisation, this is touted as a conservatorship. These entities have over $5200 billion in liabilities and they guarantee the majority of mortgages in the US. The scale of this rescue is massive and the Treasury will have to stump up a few hundred billion dollars to boost their capital.
Whatever your feelings on moral hazard, this step was probably needed to thaw the frozen credit markets. Six bank failures in two months and worries about Lehman Brother’s survival provided an unpleasant backdrop. Mortgage rates had risen to beyond 6% despite the Federal Reserve cutting interest rates to 2%. They should now come down and provide some liquidity for the housing market. Unfortunately, that is unlikely to mean a quick end to the housing malaise. Foreclosures are rising and the stock of unsold homes will take a long time to unwind, particularly as the economy enters a slowdown and job prospects become uncertain. Moreover, helping institutions finance bad assets does not necessarily mean the value of those assets will increase.
Lehman’s is an old American institution that now finds itself in the position of having to sell the family silver to raise cash after reporting a third quarter $2.9bn loss. It is mooted to be seeking a buyer for its asset management unit and property portfolios. Assets it would rather keep but needs must.
Fannie and Freddie were ‘too big to fail’ but others may not be so lucky. The important point about their rescue is that it should reduce the stress in credit markets and hopefully begin to reduce the spreads prevailing on riskier assets so that borrowing can occur at more sensible rates. That doesn’t mean that a lengthy period of sub trend economic growth will be avoided, just that its depth may now be shallower.
Meanwhile in the UK, the Bank of England will shortly publish its ideas on a permanent liquidity facility for banks in need of cash to replace the bond swaps which expire in October. Mervyn King, the Governor, has emphasised it would not be a permanent source of capital and takes the view that banks should rather sort out problems at their own expense rather than the taxpayers’.